Unit 2: Trade Policy Trade in Developing Countries 2/27/2012 Developing Countries Developing countries has no precise definition, but it generally refers to low and middle income countries. There is a large disparity between high and low income countries. Import Substitution infant industry argument – temporary protection of industries allows them to gain experience and thus economies of scale Import Substitution import-substituting industrialization – the strategy of encouraging domestic industry by limiting imports of manufactured goods Import Substitution Import-substituting industrialization was a trade policy adopted by many lowand middle-income countries before the 1980s. It aimed to encourage domestic industries by limiting competing imports. Import Substitution Import Substitution Countries may have a potential comparative advantage in certain industries, but they cannot initially compete with well-established competitors in other countries. Therefore governments should temporarily support them until they can compete internationally. Import Substitution Infant industry argument problems It may be wasteful to support industries now that will have a comparative advantage in the future. With protection, infant industries may never grow up or become competitive. Import Substitution Infant industry argument problems There is no justification for government intervention unless there is a market failure that prevents the private sector from investing in the infant industry. Import Substitution Possible market failures Because of poorly working financial markets, firms cannot save and borrow to invest in their production processes. High tariffs could be a second-best policy instead of fixing financial market. Of course a far better solution is the first-best policy: fix the financial market. Import Substitution Possible market failures Firms may not be able to privately appropriate the benefits of their investment in new industries because those benefits are public goods. The knowledge created when starting an industry may not be appropriable (may be a public good) because of a lack of property rights. Import Substitution Possible market failures High tariffs could be a second-best policy instead of establishing a system of property rights. Of course as always a far better solution is the first-best policy: establish a system of property rights. Import Substitution Import-substituting industrialization in Latin American countries worked to encourage manufacturing industries in the 1950s and 1960s. But high tariff import substituting countries grew slower than low tariff countries with export oriented growth. Import Substitution The infant industry argument was not as valid as some had initially believed. New industries did not become competitive due to of trade restrictions. Import-substitution was very wasteful: • complex, time-consuming regulations • high tariff rates for consumers • high tariff rates for firm inputs • inefficiently small industries. Trade Liberalization Countries that had relatively free trade had higher average economic growth than import-substituting countries. Many governments lost faith in import substitution and began to liberalize. In the mid-1980s India and Brazil dramatically lowered their tariff rates. Trade Liberalization Fig. 11-1: Tariff Rates in Developing Countries Trade Liberalization Fig. 11-2: The Growth of Developing-Country Trade Trade Liberalization The empirical evidence on trade liberalization is mixed. Growth rates in Brazil and other Latin American countries have been slower than under import-substitution. This slowness may be attributable to other bad policies though (lack of property rights and financial crises). Trade Liberalization India has grown rapidly. The Asian miracles Japan, Hong Kong, Taiwan, South Korea, Singapore, Malaysia, Thailand, Indonesia, and China have also grown rapidly – both in their export sectors and overall. Other factors may have played a role in the amazing Asian growth. Trade Liberalization Fig. 11-3: The Asian Takeoff Trade Liberalization Fig. 11-4: Asia’s Surging Trade Trade Liberalization It’s unclear if the high volume of exports and imports caused rapid economic growth or was merely correlated with rapid growth. Other possibilities • High saving and investment rates. • Rapid growth in education. • Other economic reforms.